Share price's relation to company's financials?

Jacksilver

If the current "Market Price" of a share is 10$ and I manage to find somebody willing to pay 500$ for it, nothing can stop us from transacting at that price.
So, at least in theory, the price is arbitrary. Yet in reality people employ sophisticated techniques of valuating risk vs. gain when investing in a particular company, based on financial (and other) data about the company.
Why bother? : )

A rational explanation for the existing behavior of players in the stock market is that there is a direct connection between your gain from owning the share (not hoping to sell at a higher price) to the actual "financial success of the company".
However, what that connection is - eludes me to this day!
Dividends are one obvious example but not all companies give out dividends.
I know I'm missing something.. Please help me figure it out.

Thanks

John Creighto

Some numbers you might want to look at are price to earnings, q-ratio and return on capital. Other interesting numbers are, is the net value of the companies assets, and the ratio of assets to liabilities.

You can view earnings as the return on the money you invested so you can make comparison of an interest rate. A price to earnings of 10 would be equivalent to a 10% return. A price to earnings of 5 would be equivalent to a 20% return. According to wkiAnswer's a typical price to earnings is about 5 to 6 times. This sounds quite attractive relative to bonds but the payment of a bond is guaranteed. The earnings of a company are not guaranteed. For instance deflation can erode the value of the earnings. Also a company could try raising capital by diluting it's shares. This represents another risk to investors Finlay unless the company issues dividends the stock owner doesn't see any of those earning directly, rather they only see the market evaluation of the stock.

Now, if a company isn't issuing enough dividends we want to look at how well, the company is utilizing those retained earnings. The return on capital gives a measure of this. By using the return on capital and knowing the percentage of the money the company keeps we can try and estimate it's growth. The q-ratio gives a measure of how susceptible a stocks value is to competition, given that if the replacement cost of a companies assets is less then the market value then in theory a new company could be created for cheaper then purchasing the existing company.

"What Does Q Ratio (Tobin's Q ratio) Mean?
A ratio devised by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets:"

If the Q values are large, it is perhaps a sign to look at the smaller companies to see if they have better valuation in these terms.

Jacksilver

I am familiar with the various valuation methods employed by investors. I didn't know about the Q ratio, so thanks for that.
However you didn't answer my question.
What is the direct advantage of owning a share of the company if it's not paying dividends?
Shares are traded like a commodity on the stock market.. but I fail to see the actual economic value of a share (the way a car for instance gives you an economic advantage - you can use it for something other than selling it at higher price...)

John Creighto

Well, the company can always issue dividends in the future. The shareholders could vote for leadership which will demand a greater divided. The advantage of a company holding on to earnings is that they reinvest it well and the company grows. As mentioned above how well they do this is measured by the return on capital. Stocks that pay dividends do better in market swings and the older you geater the greater the part of your profile you want paying income. I think it is a good idea to have a good portion of a portfolio in dividend paying stocks.

Jacksilver

So, if I understand correctly, there is no other tangible value to owning a company's share (if you don't intend to sell it at a higher price). The only value is either the Dividend or the hope for future dividends? Maybe if you buy enough shares you get to vote on company policy issues, if you want to get involved. I guess it's a form of value..

As to what you mentioned about company growth, I must say again that the actual growth is in and of itself meaningless (as I could, theoretically, find a dummy to buy my shares for 20 times the market share price and that would have NOTHING to do with the company). For the financial system to "work", players must make "rational" decisions. That is to say, you don't buy anything if it doesn't have any value to you. The value is DERIVED from promise of future income in the form of dividends, which of course is closely related to earnings and ROA and other metrics.

brainstorm

Even if you don't intend to sell a share once you buy it, you are establishing a sale-price precedent at the price you bought the share at. The seller received your payment and either re-invested it in another share, something else entirely, or spent it on chewing gum and antacid.

Why would anyone want to pay you more for a share than they could buy it for from someone else? I once attended a 4H club livestock auction where seemingly comparable animals brought very different per-pound prices. I asked someone sitting near me what the differences in price were based on and he explained that people bid higher for kids they want to give more money to for college. I thought it had something to do with the relative quality of each animal itself.

Jacksilver

Then my question is what did YOU gain by buying that Share.. what is your immediate interest in purchasing it? what will you get by owning it for all eternity? And then obviously another question is why did you agree to buy it at a price which reflects the "well being" or "potential" of some company? What was your rational for behaving this way?

brainstorm

My question is why you capitalize the word, "share?" I don't know of anyone who buys shares to hold for eternity, but if you had money that you didn't have any use for, you could theoretically buy shares of a company and hold them indefinitely. It would be less costly than buying real property, which has maintenance costs and taxes. It would also be less of a burden than buying something material that you would have to carry around every time you wanted to move it. Maybe if you're an addict of some kind, you might decide to buy shares to tie your money up so you wouldn't spend it on your fix. Maybe you want to own part of a company just to give yourself an interest in how the company functions and to be able to vote on shareholder issues.

As a long-standing shareholder, your opinion might even be listened to in a way that those of short-term shareholders are not. You could email financial news reporters and tell them you have been holding your shares of the company for 20 years but you are planning to sell if they go through with . . . X. Then, other shareholders might think you know the company so well that you can reasonably forecast pitfalls and value depreciation, and they will follow your lead in selling. If people recognized the power you had, they might even pay to lobby you to influence your opinion in their favor. All just because you have the POTENTIAL to sell your share, not because you actually sell it.

Jacksilver

I must say that I'm very thankful for all the extra knowledge I'm getting here regarding shares and behavior in the stock market.
But I feel that somehow I managed to miss the point! The "holding for eternity" bit was an exaggeration, on purpose. It illustrates that, to the best of my knowledge, the only purpose of owning a share (not capitalized, mind you) is to sell it for a higher price (that is if you intend to make a profit or benefit something financially).

I'll try to define the question clearly: Why do buyers and sellers agree to the convention that a share price should be determined according to the analysis of financial data related to the company?

brainstorm

That's a very different question. Buyer's don't agree to any conventions other than the fact that they buy it or sell it at the going rate. They can do so for any reason they want. If buyer's think a price is too high, they won't buy. If seller's think it's too low, they won't sell unless there is some benefit, such as escaping costs or because they need whatever money they can get for some reason.

Analysis of financial data and trends is tricky business. Realize that people intentionally try to stimulate buying and selling with financial news/data, so as a result there is an incentive to generate such data in a way that stimulates the market trend you want to see happen.

On the other hand, some people probably recognize certain financial data and analyses as decoys with the intent of diverting from true trends, and respond accordingly. For example, if you know that there is a bumper crop of oranges but you want people to buy to create an upward market trend so you can short-sell for more profit, then you would publish data/analyses that forecast scarcity due to freeze, disease, or whatever. Then, once the price goes up, you sell all the oranges you can to maximize your revenue (handy if there's a bumper crop), lend them to others to sell (short-sell), and then wait for the market to respond to the surplus by discounting the price.

This seems illegal to me, but I think any kind of financial/economic analysis/data is protected by freedom of speech - or is it regulated by SEC?

Jacksilver

Too high/low for what? Too high compared to the price you think you'll be able to sell? Too low compared to the price you think you'll be able to buy later or from somebody else?
If you're buying something, where is the logical explanation for thinking that you'll be able to sell it later at a higher price (or even the same price, or lower price if push comes to shove)?
What is the rationale behind looking at some board with numbers, thinking to yourself: "Yeah, that's a fair price to sell this share that I have. It's higher then what I paid for it, so I'll make some profit". And more importantly why would anybody look at that same board and think to himself: "Yeah, I think that this number on the board will be much higher in a few weeks so I better buy it now while it's low. That way I'll make a profit!"

brainstorm

People make up any rationale they want to validate their gambling habit. Stock market gambling is just gambling on how well and how quickly you can conform to speculation trends that result from publicly (and/or privately) available information. If you read or see things that you think will cause others to buy or sell, you try to get ahead of the crowd, but it is risky. If you notice what you think is a trend, and you buy into it, it is less risky except for you could be the last one on the wagon before everyone jumps off, and you lose out. It's not about the board. It's about the interaction between the gamblers. People are just pooling their money on a table and cashing out a share of it at any moment based on the amount there. If you're the last one to put your money in, you will get less out than you put in and others will walk away with your money.

Jacksilver

So, like you said, the "price on the board" is only a reflection of the going rate for a share - a rate created by the speculation of the players. Correct? Well if that's the case then my point remains the same. Why does this speculation, more often then not, even has anything to do with the company? Recently there was some bad news for TEVA regarding it's new "Copaxone". Then TEVA's shares lost some 13% value last week. That is some correlation! That was a huge fall for a company who's shares are considered in Israel to be amongst the most solid shares you can buy (it's also possible that somebody noticed the impending doom before the news were released and pulled out - that doesn't change the correlation) The CFO appeared on TV claiming that "the market overreacted". I guess the news were stronger than the CFO : )
If the players were creating the price.. What the hell were they doing listening to news about Teva? Why not look at the weather forecast for signs and trends: "Oh crap, the weather seems to be getting cooler, I should sell my share to cut losses"... "Oh yay, it seems that the weather is gonna be sunny, I should be able to sell my share for more!"

mgb_phys

Remember as a trader you are not competing with the company - you are competing with everybody else who is trading.

Suppose I think the company is good long term, I want to buy it's shares - but I want to buy them as cheaply as possible.
I put in a low bid for the shares, other people do the same - some bid lower than me.
Owners of the shares - seeing people offering low bids for them want to sell now before those low bids are the best price they can get. So the price paid for the shares that day (the market price of the company) goes down.

Jacksilver

My question remains unanswered.. Why do you want to buy it's shares if the company is good? Why the price of the share will go up if the company is good long term (I'm not talking about whether the market will respond accordingly.. you just assume it will)? Where is the unwritten law that all buyers and sellers seem to agree upon that share price has something to do with the company?

mgb_phys

The share price is just a representation of the future value of the company.

If I think a company like Apple is going to make good products in the future then I assume that it will have money and so will be worth something - I further believe that other traders will believe this and it's value will go up.

It doesn't really matter that it's valuation based on share price is a ridiculous multiple of the amount if income it gets from selling iPhones - I just have to believe that other people believe it won't go bust in order for it's share price to go up.

The value of a company is at least a little more tangible than buying and selling artwork or tulips. A company that is bankrupt is worth zero and a company with $$$ in the bank or assets is worth $$$.

brainstorm

I think what's happening to you is that you are experiencing awareness that all discourse geared toward business news or analysis consists of "floating signifiers" (Lyotard?), which means language that makes sense without necessarily having any true referent. In other words, you're exactly right that if everyone decided to sell on rainy days and buy when it's sunny, stock prices would appreciate on sunny days and depreciate on rainy ones.

Theoretically, by issuing good news about a company's business, the company is trying to raise its share price on the basis of success and thereby increase its ability to raise more investment capital. However, this does not change the fact that this is only one interest driving financial news, among others such as the desire to make easy money on buying low and selling high, or short-selling. My question is what happens when interest in money-making from speculation overshadows the interest in raising investment capital to pursue economic projects? At that point, has the economy degenerated into pure fiscalism?